Financing

You must manage your borrowings to your benefit alongside smart saving and investment decisions in order to achieve the most of out your financial situation.

Taking on an ill-timed mortgage, running a credit card tab continuously, and even rapid repayment of your student loans could be majorly detrimental to your success in building a successful portfolio of investments.

Credit Cards:

Plastic is the easiest way to deal with gaps in paychecks when buying major items, but they are also the easiest way to destroy your financial picture early. Continually holding credit card debt across several months allows interest to build on these balances anywhere from 12 to more than 20 percent. The longer you keep a balance, the more damaging the interest expense becomes, and the harder it becomes to pay the balance down. If you forget payments you will suffer nasty penalties plus potentially a higher rate on unpaid balances.

If you maintain a balance on your credit card then you are assessed an interest expense on that balance each month. This adds up to an annual loss to you of whatever your interest rate is times your outstanding balance – and since in prior sections we mentioned you should expect a long-term average cumulative growth rate of about 10 percent with equities then you can get an even better gain by paying off your credit card debt! Pay down your debt quickly, but wisely. Keep contributing to your work’s 401(k) plan as you make smart budgeting decisions to leave yourself enough savings to pay down debt.

Don’t be shy from cards, though, as they are a great source to give you a borrowing history, which will lower your costs to borrow by increasing your credit score for future events like a home purchase (i.e. you will get a lower interest rate if you have a long and strong history of taking on debt each month and paying it off in a timely manner). Use at least two cards on a regular basis but don’t spread yourself too thin with cards from every retailer you visit once a year. Too many credit cards outstanding gives you the chance to forget payments and also increases your risk level as seen by lenders since you have the ability to take on a lot of debt quickly.

Student Loans:

Though annoying to have an overhang, don’t rush to pay off your student loans since your interest rates on these loans likely ranges from 4 to 7 percent. This rate is well below returns you can expect by fully funding your 401(k) to get an employer match and long-term equity return averages of about 10 percent. So, look at your budget and set your monthly payment to give you the ability to fully contribute to your 401(k) and still have some scratch left over to start building some personal savings. Student loans are not viewed as “bad debt” unlike consumer debt like credit cards, so a lingering student loan balance will not significantly hurt your credit score.

Look at the various lenders you have for your student loans and see if you have the ability to consolidate with one lender at a lower overall interest rate. Consider using a fixed rate refinancing provider like www.sofi.com and stretch the repayment length out over a longer time frame. This way your monthly payments are lower and you will have more flexibility to save and invest. If you save the difference in the payments between a 10-year and a 15-year repayment schedule then you will hopefully have a sizable amount of investment assets after a 10-year period. Then, you can pay down the remaining balance if you wanted to and you are in the same position! Or, you can keep those funds invested and gradually and strategically pay down your debt while building your investment assets.

Use the annoyance of having the overhang of student loans as motivation to save and invest so your children can have their tuition covered in full due to your wise investing. If you have a little one already then open a 529 college savings account and start monthly contributions early to give them time to see potential long-term investment gains (learn more about 529 plans here).

Home Mortgage:

The decision on whether or not to purchase a home should be a very long and deliberate thought process for you. This will require an extraordinary investment of money and time in order to get approved for a loan and close on the home, and you will also have taken on a very sizable illiquid investment (meaning you won’t be able to sell your home quickly if you need the money you invested in it).

Generally, you should not purchase a home if you don’t see yourself living in that location for at least five years, the longer the better. Consider purchasing a home if you have job security, are comfortable living in that location for beyond just several years, and if you have money saved for a down payment and an increased “buffer.” There is an extraordinary risk in buying a home since as seen in the past few years prices can drop significantly in the near-term. Below is a chart of a home price index for the largest 20 U.S. cities compiled by Standard and Poors:

This index began in Jan 2000 – so the index shows price movement relative to that date. Note how the index rose more than 100 percent from 2000-2006 but then abruptly fell more than -25 percent through early 2009. In some cities like Las Vegas, NV, home prices fell by more than -50 percent in this time period! The lesson is home prices can be volatile so don’t look at home ownership as a steady and safe investment.

Should you have purchased a home in 2005-2006 at the peak then in 2012 you could potentially have a loan of $200,000 on a home that is now only worth $150,000! The risk of price declines and you ending up with debt in excess of the value of your home is a good reason to think long and hard before buying a home.

Though there are risks involved with homeownership, and recent homebuyers may have been burned due to price declines, there are still many benefits of becoming a homeowner. With a mortgage payment, you are slowly but steadily paying down the principal on your loan through each monthly payment (meaning you are decreasing the amount you owe on the home). This means you are decreasing your debt levels, and thus leaving you with equity in your home (seen as the value of your home minus the amount of debt you owe on the home). The amount of your mortgage payment that goes to interest is also tax deductible up to certain limits, which means your tax bill will be lower if you take on a mortgage.

Download our spreadsheet that breaks down mortgage payments into an “amortization table” – this shows how your monthly mortgage payments are broken down into interest payments and principal payments. At the beginning of your mortgage, you are primarily paying interest to the bank, but the amount of your monthly payment that goes to paying down the principal on your loan steadily increases over time.

This spreadsheet is made so you can adjust all of the cells with blue font to fit your loan. The variables will be the size of your loan, how much of a down payment your loan requires (likely either 3 to 5 percent for a federally insured “FHA” loan or 20 percent for a conventional mortgage), and the interest rate on your loan. There is also a series of complete guesses about the future movement in home prices – adjust these variables for a worst-case scenario to see if you have any equity in your home if you buy a home and prices decline over several years. If this is not an acceptable case for you then you should continue renting or you should plan on staying in your home for a longer time to pay down more principal.

You will see that even with moderate declines in home values over several years you may still be able to see a gain on your home investment due to your slowly declining principal balances on your loan. Keep this table updated to track the number of mortgage payments you have made to follow the amount of equity you potentially have in your home.

Another huge argument for purchasing a home is the historically low level of interest rates. The following table shows a nationwide average interest rate for a 30-year mortgage as compiled by Freddie Mac’s Primary Mortgage Market Survey:

Lower interest rates mean less of your monthly mortgage payment goes to interest coverage and more towards paying down the principal debt amount of the loan – allowing you to gain more equity in your home.

Homeownership, in the long run, is a great way to see a return on the money you spend for your living expenses instead of just cutting a check for rent, however it is risky for young professionals due to the down payments required, the potential for price drops, and the likelihood that you won’t stay in the same place for long periods of time. Also consider the many extra expenses involved with home ownership that previously your landlord would have covered (local property taxes, appliance upgrades, repairs, maintenance, gardening etc.) … these are all now yours to bear!

If you have a steady job, love where you live (and want to be there for 5+ years), find a good price on a home, and you have built up a strong “buffer” so you can afford a down payment and also ensure you won’t miss mortgage payments, then you may want to consider buying a home to take advantage of historically low mortgage rates. Whew – that’s a mouthful! Just goes to show that many pieces must be in place in order for buying a home to be a good decision. 

If everything fits then approach several local banks to begin the incredibly long and detailed loan process (which we won’t try to detail here) to ensure you are getting the best mortgage. Focus on a 30-year fixed rate mortgage to lock in a low rate that isn’t subject to rate increases, and to stretch out your repayment horizon so that your monthly payment is lower, allowing you to fund other investment accounts. If anything is missing then keep saving and investing your excess money and eventually you will find a situation where everything fits.

Car Financing:

Before buying a car let us go back and highlight one of our investment principles: Live beneath your means. This is meant to encourage you to think if you really need to buy a new car or if what you currently have or a model several years older would do just as good. Cars are a rapidly depreciating asset, meaning they quickly decline in price soon after you buy them and steadily decline in value over time. Thus they (like other items in their same category including clothes, furniture, jewelry and electronics) should go through extra scrutiny to determine if you really want and/or need them!

Again, you don’t want to not enjoy your hard earned money … and if cars are what you really enjoy then you should enjoy them! But you should know that this enjoyment is a terrible investment decision. If you can avoid it then it is very wise to do so – take the money and instead increase your 401(k) contribution or increase the amount you send to your personal brokerage account. That way your money has a chance to grow instead of getting a guaranteed loss through a car purchase!

Leasing a car is an even worse option since you can’t keep the car at the end of the lease term and don’t get the trade-in value of your vehicle at the end of your term. Look for dealer financing incentives in the form of low-interest rates on a 3-5 year car loan. Rates will be lower on shorter-term loans, but the payments will be much higher. Do not put an excessive amount of money down since auto loans these days carry very low-interest rates.  

Your best bet would be to buy used cars in order to avoid a huge immediate price drop on a new vehicle … and avoid any new and fancy cars until later in life when you can actually afford one. Maybe buy one gently used or an affordable new car with a five-year loan term, keep it for 10 years and then pay cash for the second purchase.